What is a golden cross?
A golden cross is a technical analysis indicator that is formed when the short-term moving average crosses above a longer-term moving average, according to MarketBeat. Traders consider this cross over as a bullish signal for those with long positions and an exiting signal for those who short the market.
The opposite of a golden cross also happens. That is a long term moving average can cross over a shorter-term moving average. When this happens, the event is described as a death cross. A death cross marks the beginning of a downtrend, and therefore, it is used as a buy or sell signal depending on trading strategies.
How to interpret and validate a golden cross?
A golden cross will occur when a short-term moving average crosses over a long-term moving average. An illustration of a golden cross is shown in the following chart.
Moving averages are great indicators that smooth data and predict price trends. A combination of multiple moving averages can be used to show short term and long term sentiments about a particular stock or sector.
When two moving averages cross each other, it indicates a possible change in the trend. For example, if a long term moving average crosses above a short term moving average, a downtrend will most likely follow. Investors use this information to make trades (buy or sell) depending on their trading strategies.
How to validate a golden cross?
Like any other indicators and trading patterns, investors should validate a golden cross before making investment decisions. That is every golden cross does not turn into a bullish move.
So, how can you validate a golden cross?
To answer this question, we must understand forces that move prices in the market.
Everything in the market depends on supply and demand. More supply will cause prices to go down. On the other hand, more demand will cause competition among buyers. Hence, an increase in prices.
So, how can you sense the change in supply and demand?
The following tips can be used by investors to validate a golden cross
- Volume: The volume is one of the most important factors to consider when trading. The trading volume will tell you how many shares are being bought and sold at a given trading period. If the golden cross is followed by a heavy buying volume, it will indicate a strong golden cross. That is, there is more demand for the stock compared to supply. On the other hand, a golden cross without a supporting volume will most likely be a false golden cross. Even if the price moved up, there is not enough demand for the stock to increase the competition among buyers.
- Trend: The trend is another important indication of a golden cross. The trend should move in the anticipated direction. Since the golden cross signals a bullish movement, the trend should go up right before the golden cross. This is because as candlesticks close higher and higher, the short-term moving average moves higher until it crosses the long-term moving average.
- Should happen after a strong sell-off: A strong sell-off shows that more shares have been sold. As sellers give away their shares, the price tank until it hits the bottom. The stock becomes very cheap until there is no more selling pressure. This is when buyers start jumping into the market and push the price in an uptrend. To know if a stock experienced a major sell-off and becomes cheap, investors can use the relative strength index (RSI). This indicator shows if a stock is overbought or oversold. In our case, the stock will be oversold and there will be less supply.
- Other indicators should help in confirming a change in the trend
How to trade a golden cross?
Traders take long positions after the golden cross happens with supporting evidence. That is the stock shows a higher buying volume, the trend is moving up, the stock is oversold, and more importantly, other indicators such as momentum indicators confirm the change in trend and momentum.
Uptrend confirmation becomes an exit signal for traders who shorted the stock. Shorting a stock means that a trader sells the stock and buys it back later at a cheaper price.
Having an uptrend confirmation means that the price will go much higher. This is why traders buy shares to cover their positions when a golden cross happens.
